In the early 1990s, banks developed credit derivatives contracts by purchasing protection from insurers in order to manage the banks' exposure to corporate loans on the banks' books. Moreover, the 1988 Basel I Accord and associated rules required banks to set aside a greater percentage of their capital against outstanding loans. Banks preferred to transfer loan risk to entities that weren't subject to the same capital reserve requirements, and used credit derivatives to transfer risk while retaining the ownership and profits of their loans.
The credit derivatives market has experienced considerable growth since then. This growth has been driven by an increasing realization of the advantages credit derivatives possess over the cash alternative, plus the many new possibilities they present. The primary purpose of credit derivatives is to enable the efficient transfer and repackaging of credit risk. The typical definition of credit risk encompasses all credit-related events ranging from a spread widening, through a ratings downgrade, all the way to default. Banks in particular are using credit derivatives to hedge credit risk, reduce risk concentrations on their balance sheets, and free up regulatory capital in the process.
In their simplest form, credit derivatives provide a more efficient way to replicate in a derivative form the credit risks that would otherwise exist in a standard cash instrument. For example, a standard credit default swap can be replicated using a cash bond and the repo market. In their more exotic form, credit derivatives enable the credit profile of a particular asset or group of assets to be split up and redistributed into a more concentrated or diluted form that appeals to the various risk appetites of investors.
The default swap has become the standard credit derivative. For many, it is the basic building block of the credit derivatives market. According to the British Bankers' Association Credit Derivatives Survey, it dominates the credit derivatives market with a significant portion of the outstanding notional. Its appeal is its simplicity and the fact that it presents to hedgers and investors a wide range of possibilities that did not previously exist in the cash market.
A default swap is a bilateral contract that enables an investor to buy protection against the risk of default of an asset issued by a specified reference entity. Following a defined credit event, the buyer of protection receives a payment intended to compensate against the loss on the investment. This is shown in FIG. 1. In return, the protection buyer pays a fee. For short-dated transactions, this fee may be paid up front. More often, the fee is paid over the life of the transaction in the form of a regular accruing cash flow. The contract is typically specified using the confirmation document and legal definitions produced by the International Swaps and Derivatives Association (ISDA). Despite the rapid moves toward the idea of a standard default swap contract, a default swap is still very much a negotiated contract. There are, therefore, several important features that need to be agreed upon between the counterparties and clearly defined in the contract documentation before a trade can be executed.
The first thing to define is the reference entity. This is typically a corporate entity (“corporate”), bank, or sovereign issuer. There can be significant differences between the legal documentation for corporate, bank, and sovereign linked default swaps.
The next step is the definition of the credit event itself. This is obviously closely linked to the choice of the reference entity and may include the following events: (1) bankruptcy (not relevant for sovereigns); (2) failure to pay; (3) obligation acceleration/default; (4) repudiation/moratorium; and/or (5) restructuring. These events are defined in the ISDA 2003 Credit Derivatives Definitions.
Some default swaps define the triggering of a credit event using a reference obligation. The main purpose of the reference obligation is to specify exactly the capital structure seniority of the debt that is covered. The reference obligation is also important in the determination of the recovery value should the default swap be cash settled (see FIG. 1). However, in many cases the credit event is defined with respect to a seniority of debt issued by a reference entity, and the only role of the reference obligation is in the determination of the cash settled payment. The maturity of the default swap need not be the same as the maturity of the reference obligation. It is common to specify a reference obligation with a longer maturity than the default swap.
The contract specifies the payoff that is made following the credit event. Typically, this will compensate the protection buyer for the difference between par and the recovery value of the reference obligation following the credit event. This payoff may be made in a physical or cash settled form. The protection buyer will usually agree to do one of the following:                (A) Physically deliver a defaulted security to the protection seller in return for par in cash. Note that the contract usually specifies a basket of obligations that are ranked pari passu that may be delivered in place of the reference obligation. In theory, all pari passu assets should have the same value on liquidation, as they have an equal claim on the assets of the firm. In practice, this is not always reflected in the price of the asset following default. As a result, the protection buyer who has chosen physical delivery is effectively long a “cheapest to deliver” option.        (B) Receive par minus the default price of the reference obligation settled in cash. The price of the defaulted asset is typically determined via a dealer poll conducted within 14-60 days of the credit event, the purpose of the delay being to let the recovery value stabilize. In certain cases, the asset may not be possible to price, in which case there may be provisions in the documentation to allow the price of another asset of the same credit quality and similar maturity to be substituted.        (C) Fixed cash settlement. This applies to fixed recovery default swaps, which are described below.        
The first two choices are shown in FIG. 1. If the protection seller has the view that either by waiting or by entering into the work-out process with the issuer of the reference obligation he may be able to receive more than the default price, he will prefer to specify physical delivery of the asset.
Unless already holding the deliverable asset, the protection buyer may prefer cash settlement in order to avoid any potential squeeze that could occur on default. Cash settlement will also be the choice of a protection buyer who is simply using a default swap to create a synthetic short position in a credit. This choice has to be made at trade initiation.
The protection buyer stops paying the premium once the credit event has occurred, and this feature has to be factored into the cost of the default swap premium payments. It has the benefit of enabling both parties to close out their positions soon after the credit event and so eliminates the ongoing administrative costs that would otherwise occur. Current market standards for banks and corporates require that the protection buyer pay the accrued premium up to the credit event; sovereign default swaps do not require a payment of accrued premium.
The details of an exemplary default swap trade are shown in Table 1. The example is a £50 million, 3-year default swap linked to Poland. The cost of the protection is 33 bp per annum paid quarterly. The cash flows are shown in FIG. 2. The size of each cash flow is given by £50 million×0.0033×0.25=£41,250. The figure shows both the scenario in which no default occurs and the scenario in which default does occur. If default occurs and the recovery rate on the defaulted asset is 50% of the face value, then the protection buyer receives £25 million.
TABLE 1Details of an Example Default Swap TradeDefault Swap DetailsCurrencyEuroMaturity3 YearsReference EntityPolandNotional$50mDefault Swap Spread33 bpFrequencyQuarterlyPayoff upon DefaultPhysical delivery of asset for parCredit Eventsee section 6.1 for a list of credit events
A default swap is a par product: it does not totally hedge the loss on an asset that is currently trading away from par. If the asset is trading at a discount, a default swap over-hedges the credit risk and vice-versa. This becomes especially important if the asset falls in price significantly without a credit event. To hedge this, the investor can purchase protection in a smaller face value or can use an amortizing default swap in which the size of the hedge amortizes to the face value of the bond as maturity is approached.
Preferred stock is well-known—generally, it is stock that pays cash dividends on a regular basis (typically quarterly), that is senior to common stock (but junior to company debt), and has no voting rights. In the past, offshore investors were strongly discouraged from investing in cash preferreds due to negative tax implications (withholding tax on all dividends). Also, historically there has been limited liquidity in the preferred market. Other drawbacks include:
(a) Limited ways of being short—no way in derivative form to get short a credit in the preferred level of the capital structure;
(b) Limited ways of hedging preferred “credit risk”—while taking the structure risk;
(c) A more limited delivery universe and fewer credit events—no derivative reference product which allowed:                (i) delivery of a preferred security on a credit event; or        (ii) dividend deferral/non-payment on a preferred/trust preferred as a credit event;        
(d) No preferred dividend deferral feature in standard CDS contracts.
Thus, there is a need for:                a derivative instrument that can be used to hedge preferred investments;        a derivative instrument that can replicate a preferred in subordination and deferral trigger;        a derivative instrument that generically references the preferred part of the capital structure and can serve as a pricing benchmark; and        a product that educates investors by increasing the focus on the hybrid capital market.        